An extremist, not a fanatic

October 17, 2012

In defence of the structural deficit

Tim Worstall points to the estimate* that the UK ran a cyclically adjusted government deficit of 5.2% of GDP in 2007 and says:

It’s really most unKeynesian to be running a deficit of that sort of size at the top of the longest boom in modern history, isn’t it?...Keynesianism doesn’t work..because policitians will never run the associated surpluses in the booms.

However, I'm not sure this episode supports Tim's scepticism. The structural budget deficit is the sort of pseudo-scientific concept that brings economics into disrepute.

Let's imagine GDP is at its potential level. What should government borrowing be? It all depends upon the private sector's financial balance; this, by definition, is the counterpart of the government's financial balance. If the private sector has a net deficit - because it is investing more than it is saving, then the government will have a surplus. And because, ex hypothesi, GDP is on trend, it'll have a cyclically-adjusted surplus.This is what happened in the late 80s.

If, however, the private sector has a surplus, then the government will have a deficit. This is what happened in 2007.Companies and foreigners were then running surpluses. So someone had to run a deficit. Because households weren't running a big enough deficit, that someone had to be the government.

To put this another way, companies weren't investing as much as they should have, and foreigners weren't buying enough of our goods. Government spending filled the gap. Yes, economic activity was strong. But this was because the government ran a deficit to sustain economic activity. In this sense, the deficit was entirely consistent with orthodox Keynesianism.

Two things make me say that the government was a passive responder here, rather than a profligate borrower:

1.As the government deficit rose, real interest rates fell; long-dated linkers yielded 1% in late 2007, half the rate they did in 2003. This is consistent with a savings glut - by foreigners and corporates - driving down real interest rates, which the government tried to resist by borrowing more. If markets had been spooked by a "structural deficit" in 2007, rates would have risen. They didn't.

2. Inflation was quite well-behaved in the mid-00s; it ended 2007 at 2.1%, near enough bang on target. This suggests the government deficit was not adding much to inflation, as not overheating the economy.

You might object that whilst there was little goods and services inflation, there assuredly was house price inflation.

True. But this was, arguably, despite the fiscal deficit, not because of it.Imagine the government had tried to run a surplus in the mid-00s in the face of the corporate and overseas savings gluts. This would have added to the incipient weakness in activity. The Bank of England would have responded by cutting interest rates. And this might have raised mortgage lending and house price inflation even more.In this sense, one could criticise the Labour government for not running a big enough deficit - for not doing enough to raise interest rates to choke off what proved to be a ruinous asset price bubble.

Now of course, you can criticize Labour for spending badly, and for choosing to spend rather than cut taxes. But you shouldn't blame it for running a deficit. And you shouldn't think it anti-Keynesian to have done so.

* I think the Telegraph report is referring to statistical table 2 of this pdf: old media aren't good at links.

Direction of causation is the issue. Is the public sector forced into deficit spending as a passive response to private sector saving, or is the private sector saving as a Barro-Ricardian response to public sector deficit spending - i.e. in the expectation that there will have to be higher taxes to pay for it, as D says?

Similar to frances coppola, this is one of those few things that you commonly write where i think 'wow, you are saying that private spending is exogenous!', how can private actors coordinate that! It doesnt make sense on its own unlike most of your stories. I suppose it makes more sense if you add in the assumption that the public sector is forced/choosing to defend a positive real interest rate for savers. Then private sector saving forces the pubic sectors hand.

But if thats true, thats insane and terrible public policy! Its a massive subsidy to savers that we cannot afford if the real rate of interest is negative, whether that is due to contingent elements of the economy or due to technological stagnation.

Is not the big picture here as some other economic bloggers have claimed, that China has gone through a massive Capitalist industrialisation but still has a state run financial system. So you have massive profits as in the British Industrial revolution and forced savings and lending. So Britain and the USA could increase their consumption via saving in China, and why not?

If people for what ever reason will lend to or invest in your economy and allow you to consume much more why is that bad? Keynes would say that it is not the boom but the bust that is the problem and the bust is a capitalist failure from poor regulation of finance. But a boom that allows you to eat more restaurant meals or built public infrastructure or have higher welfare benefits if your a claimant is quite fine. If we had not borrowed the savings they would have gone else where or world output would have been lower. So we would have been poorer and China would have been poorer as well. Some one must use the savings or they become worthless.

All of these politicised discussions about economics seem to skirt around the underlying issue of opportunity cost and uncertainty. Unless some one can think up plausible counter factual policies the conclusions from these arguments are unfounded.

Only an economist could think it plausible that the global savings glut, which is the root of our current economic crisis, was a concerted private sector response to a hypothetical (global!)future tax hike, rather than a consequence of mercantilist policies and hoarding of wealth by the new global super-rich.

Right-wing economic policies from the 1980s have inflated the wealth of the rich everywhere, from US to China, at the expense of the rest of us. The resulting tsunami of wealth has chased return around the globe, driving down real interest rates and creating the credit bubble. In the process, it stuffed the pockets of the bankers with gold - they came up with ever more risky financial engineering to inflate their bonuses and milk this global cash cow. When the balance sheets toppled, governments were left to pick up the pieces and take the blame.

Its a simple story, and far more plausible than tales of 'Barro-Ricardian' response dreamt up by economists who have left the shores of real economic life a long way behind.

Instead of running big budget deficits, wouldn't it have been better to impose heavy tariffs on goods from China and other mercantilist countries, preventing the overseas savings glut from happening in the first place?

@ Frances, Nick, Philip - I am saying that in this case, the private sector's surplus was (largely) exogenous. I do so for 3 reasons:
1. There are plausible causes of such a surplus - the Asian savings glut and "great stagnation"/dearth of investment opportunities.
2. If the causality were the other way round - with the public deficit causing a private surplus - you'd expect to see real interest rates rising so that a higher cost of borrowing reduced private sector investment. But in fact interest rates fell.
3. It's possible in theory that the public deficit raised private saving thru Barro-Ricardo equivalence. But why did this cause companies to save in anticipation of higher tax whilst households borrowed. Were agents expecting really expecting a shift in the tax burden? Or isn't it more likely that such equivalence just didn't hold?
@ Philip - there's nothing unique about the state being incapable of controlling its own budget. Why do companies make losses?

Chris: fair point. I think I might have been confusing gross expenditure with net deficit.

Perhaps I should ask about two of the other questions which always bug me when this kind of argument comes up. Firstly -- though I may be misunderstanding the argument -- I thought this was about cashflow accounting. Is that right? Because companies can be loss-making but cashflow-positive, and vice versa.

Secondly, we tend to attribute different reasons for a single company making a loss from the reasons you are giving for the state being in deficit. This is probably partly to do with the fact that we are treating the state both as a monolithic single economic agent (not unlike a giant company) and also as a sector in its own right: but then, what if we treated Tesco as a sector in its own right?

Tesco is a much smaller player than it's government but crucially it's a currency user, while the government is a currency issuer or creater. Government excess spending into the economy supplies the money demand needed to pay taxes and net save and if large enough, balances aggregate demand and supply at a full employment, stable prices equilibrium. There is no need for a currency issuer to borrow what it can create out of thin air as Jens Weideman let alone Ben Bernanke and Alan Greenspan have acknnowledge; you might want to read up on Beardsley Ruml's side note that taxes for revenue are obsolete.

Another way of looking at it is that if government deficits are less than desired foreign and private surpluses, there will be over supply/under demand and mass unemployment aka the last 30 odd years of so called great moderation.